WASHINGTON – After a strange Tuesday, Iran and oil prices continue to trouble Wednesday trading action on Wall Street. But an unexpected economic snag in the nation’s financial fabric may cause some surprises in today’s upcoming 2 p.m. ET Fed announcement on interest rates. Most analysts, though not all, expect another 0.25 percent reduction in interest rates. But beneath the hood, the Fed has also been forced to act on the liquidity front. In so doing, the Fed has reluctantly morphed into a metaphorical Repo Man. In the economic sense. And the Fed’s Repo Man activities may inject a surprise twist into the Fed’s opinings today.
Repo Man, the movie
Film fans might recall Repo Man, the movie. That weird, 1984 cult classic put space aliens, punk rockers, two-bit thieves, cops and the Federal government into a blender. Along with one very weird car. And out came a low budget action-horror-black comedy that delighted audiences looking for a novel experience at the cinema.
A repo man, of course, is a guy (sometimes two) that prowls your neighborhood looking to repossess cars that are way delinquent on their monthly payments. But that kind of repo man bears no resemblance to what’s going on in today’s short term money markets.
The Fed’s version of Repo Man is very different
That’s because the term “repo,” as it’s used in the banking and finance business, has little to do with automobile bounty hunters. The term is shorthand for short term borrowing deals in the financial marketplace. Unfortunately, this gets complicated. So let’s turn to Investopedia for a reasonably understandable definition.
“A repurchase agreement (repo) is a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day.
“For the party selling the security and agreeing to repurchase it in the future, it is a repo; for the party on the other end of the transaction, buying the security and agreeing to sell in the future, it is a reverse repurchase agreement.
“Repos are typically used to raise short-term capital.
What we’re talking about here specifically is the customary short-term buying and selling of large gobs of money between, in this case, the Federal Reserve Bank and the banking and investment banking industry. This kind of activity goes on every day. And the Fed is often the go-to “repo man” for large scale transactions.
A little more on what repo means in the banking sector
To oversimplify, repos via the Fed or other banks or corporations provide the short term cash liquidity that the economy needs to keep goods, services and longer term lending moving smoothly.
But in recent weeks, that liquidity has dried up, primarily because of the Federal Reserve’s over-eager and overly optimistic “balance sheet runoff.” Which means that until recently the Fed has been quite rapidly allowing more and more of its massive inventory of bonds and loans to mature and expire without refinancing them.
Recall that the Fed bought this trainload of debt way back when. The original purpose: to inject liquidity into the economy during, and long after, the Great Recession.
On paper, allowing this gargantuan overhang of debt to gradually run off in an improved US economy makes a lot of sense. Carrying that debt load indefinitely with, effectively, borrowed money from American taxpayers could, over time, add too great a burden on the Fed and the Treasury. So getting rid of the Fed’s huge balance of borrowed debt instruments, they figured, would rationalize the government’s budgets and bring normalcy back to the system.
Today’s Fed tends to overdo things, creating economic problems we don’t need
Problem is, they overdid the return to normalcy thing. President Trump is right. The Fed screwed up as usual. They moved too far and too fast and started to crimp the machinery of business and banking. This may, in fact, be why we have yet to approach the widely ballyhooed upcoming recession.
Even after this year’s notorious rate inversion – in which short term debt bizarrely offers a higher rate of return than long term debt – a recession doesn’t seem to be in the offing. But maybe that’s because the Fed threw everything out of whack by jacking up interest rates too fast and by letting its balance sheet run off way too fast. Before reversing course, hopefully just in time.
This week, the Fed, has acted as the government’s repo man of last resort. The nation’s central bank has already been forced not once but twice to inject large amounts of cash into the system. As in tens of billions of dollars. Otherwise, unbeknownst to most Americans, the country would suddenly be facing a serious liquidity crisis. The likes of which we last experienced at the outset of the Great Recession. We need an instant replay of that miserable era like we need a hole in the head.
Financial gurus explain repos. Get out your dictionaries
We also need, at this point, to bring in a financial guru or two to explain this esoteric monetary repo man stuff. Most of us, including me, can’t always grasp the mysterious ways in which America’s great finance engines function.
The twin Tylers at ZeroHedge always seem to find the right guys to explain this stuff. And provide a scary chart to illustrate the problem. (As usual, bold and itals below are via ZH.)
“‘This [repo mess] is a big deal,’ warns Nomura’s Charlie McElligott – a man not known for hyperbole – as he reflects on the sudden, dramatic changes occurring in the very deepest levels of plumbing of the world’s supposed most-liquid markets.
“Another massively over-subscribed repo liquidity injection this morning, coupled with The Fed’s dramatic loss of control of rates suggest what McElligott calls a ‘potential mega-shift’ in policy from The Fed.”
Here’s a Bloomberg chart from ZH that illustrates this morning’s bizarre action.
More from Nomura smart guys
“Nomura Chief Economist Lew Alexander shifted his call for today’s FOMC meeting to include:
“An announcement that the Fed will resume the expansion of the balance sheet again in coming weeks (in addition to a 25bps [basis point] cut and likely announcement of ongoing ‘as needed’ repo transactions in order to maintain short-term interest rates within a range that is consistent with the target range for funds rate…
“McElligott’s Bottom line:
“Due to the acute nature of the $funding stress dynamic in recent days, I believethe delta of a Fed ‘balance sheet expansion’ headline today … is significantly underpriced in the market and risks catching investors ‘off guard.’”
So what do these folks mean in plain English. Let’s try these bullets:
- The Fed has screwed up over the past year, trying to return us to a flavor of pre-2006 “normalcy.”
- They did so by simultaneously employing not one but two aggressive moves to start pulling more and more of the money out of the financial system to reduce the Fed’s – and the Treasury’s – effective balance sheets. They’d added that money years ago by successive QE (quantitative easing) moves to inject massive amounts of liquidity into the US economy.
- But, as President Trump duly noted, 24/7, they moved too fast on both fronts to squeeze the immense and longed for re-inflation of the US economy. Ditto the long-awaited middle-class economic recovery that Barack Obama stifled for 8 long and painful years. I.e.,the Fed underestimated how fast they could do this without killing the recently revived golden economic goose.
Moving right along…
- Now, the Fed is effectively doing at least a short term version of QE to mitigate some of the effects of this ill-advised overshoot. They’re on the verge of completely reversing their earlier policies.
- Likewise, they’ll likely cut interest rates today by a quarter of one percent. And may signal one more cut this year. (Or not.)
- Finally, what the above analysts are hinting is this. If markets correctly figure out what’s going on underneath the hood, we could soon have a problem. In short order we could get a massive, perhaps too massive rally in the stock market. One that nobody thinks can happen.
- Or, contrariwise, if they don’t like what they hear from the Fed, on balance, it could be “clobberin’ time,” to borrow a phrase from the Fantastic Four’s “Thing.”
- Meanwhile, background noise continues. China continues to make nice sounds this week on trade (perhaps signifying nothing in the end). And with everyone on hold re: nuking Iran, the international stuff that’s recently scared the market is back in its box. For now.
- With that pressure temporarily removed, we now await another painfully worded oracular pronouncement from the current Fed. A bunch of Wrong-Way Corrigans if I’ve ever seen one.
Sorry about all the confusing gobbledygook today. Some of this economic stuff is just too hard to explain in plain English. Which is a big problem for most of us. Maybe we should simplify our financial systems.
Meanwhile, stay tuned. I’ll append a short update to this piece this afternoon, sometime after 2 p.m. Or when the smoke clears. Stocks are negative to flatline as of the noon hour. But things could change a lot later this afternoon.
The Fed did cut the Fed Funds rate by another 0.25 percent as analysts widely predicted. But, Wrong-Way Corrigans to the end, they seem to have put the kibosh on further cuts in 2019. And perhaps 2020. Predictably, stocks are slowly and surely tanking across the board. The Dow is off 166 points and sinking as of approximately 2:30 ET, and the other averages decided to follow suit. That likely kills any chance of a strong market recovery this week, given that Friday is the always volatile quadruple witching hour for September, the quarterly event during which every option known to man seems to have its expiration date. We’ll be back tomorrow with a further assessment.
– Headline image: Screen capture of a scene from the movie Repo Man. Universal Pictures film, 1984. Fair use citing related point.